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The Diligent team
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Five best practices to prevent insider trading

November 19, 2018
0 min read
Image of money representing the five best practices to prevent insider trading

Insider trading has been a buzzword for the last two decades. We think of New York Congressman Christopher Collins, Martha Stewart and the bacchanalia of Martin Scorsese's The Wolf of Wall Street. Little discussed, however, is that the greatest risk facing corporations with respect to insider trading is not greed or malicious intent, but negligence. Most instances of insider trading are preventable, at least on a corporate level. There are checks and balances that can be installed to insulate the corporation from allegations of wrongdoing in cases of insider trading ' the non-negative returns on which can be substantial. Although corporate criminal fines for insider trading are capped at $25 million, the penalties for other charges associated with insider trading activities can far exceed this number.1 With that in mind, here are five best practices to prevent illegal insider trading:

Strategy 1: Restrict risky trading

A popular strategy to reduce the risk of violating insider trading rules is to restrict employee trading on company-owned securities at specific times, such as the weeks around when earnings reports come out. Earnings reports will detail the projections for company-owned securities, and as such, while they are compiled, there may be opportunity for those looking for privileged material information to find it and trade based on it. This approach removes the ability to trade on any insider information at all ' thus insulating the corporation by circumventing any intent to do so. A more extreme version of this tactic is to maintain a list of securities in which employees may not trade at any time.

The positive example of the approach illustrated above is necessitating clearance for employees trading in company-backed securities by the legal division, whether via the chief legal officer or a designated member of their office. This will allow for what is known as legal insider trading, that is, trading of securities by corporate insiders based on information that is also available to the public. Some of these practices are industry standards, some are a little more radical, but the truth is you will have to do some work to determine which of these restrictions and approval processes might be the most efficient combination for keeping both your employees and regulators happy.

Strategy 2: Appoint an in-house watchdog

Instead of simply relying on your employees to submit clearance requests for trades of covered securities, one way to ensure compliance, for posterity's sake, is to mandate employee submission of statements from the brokerages that they personally use ' combined with attestations from each employee that their submissions of trades are accurate, this can be a powerful deterrent against insider trading on the securities owned by your firm. Not only are companies that implement checks on their insiders' trades going to have more success in discouraging insider trading, but with a reputation for not looking the other way, they are less likely to be investigated by regulators.

This can involve two levels of checks. First, an in-house 'watchdog' position, where there is oversight on the trades made by insiders. The second level is a third party, where an impartial entity, such as a corporate accounting firm, will match up the trades your employees actually made with the ones they submitted for clearance ' this is done by investigating personal holdings that are relevant to possible illegal trades.

Strategy 3: Ensure that your employees are educated on insider trading

Insider trading is easier to commit than most would like to admit. Having a robust training program that not only acknowledges this, but drives home just how serious the penalties for insider trading are ' for both insiders and the companies they work for ' is integral. This should cover all possible instances of insider trading. These can range from a speculative conversation on the future of a security with a family member or friend, to purposefully shirking blackout periods to trade on covered securities, which hammers home the point that not all insider trading is preventable by the firm in which it happens, but the firm will be in the best possible position with these measures in place.

Strategy 4: Act quickly to investigate insider trading

Should one of your employees come under scrutiny for their personal trading, it is imperative to move as quickly as possible to assess the legitimacy of the allegations. Launching an investigation will involve judging whether this was an isolated incident, and whether any other employees exhibited similar trading patterns. It should be clear after due diligence, however, whether insider trading has been committed or not. Most savvy trades are made with information that informs a decision on what to do with a security; however, what delineates legal and illegal insider trading is whether the information used to make the trade is publicly available. Determining what information your employee used to make the trade that is being questioned will be key to determining whether the firm has any liability. Tracking the paperwork available for the covered security is a complex process.

Strategy 5: Leverage technology to prevent insider trading

Some of these options simply boil down to having additional personnel to monitor, log and clear trades ' but this isn't always necessary. There is a class of software known as Insider Trade Management Systems (ITMS), which is available in legal entity management software.

In order to use an ITMS and automate the processes that will allow the company a greater degree of insulation from potentially damaging suits regarding insider trading, a robust entity management platform is a must. Being in control of the flow of documents that are the lifeblood of the corporation and that detail the key individuals, statutory filings for each corporate entity, shares and shareholders will allow for a strong basis to monitor the trades of individuals who are in a position to profit from material information.


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